What the hell is going on in Europe?

This week has been particularly confusing when it comes to the European debt crisis. It’s complicated enough to think about the various countries, with their various current debt problems, future debt problems, and austerity plans, not to mention how they typically interact at the political level versus how the average citizen is affected by it all. But this week we’ve seen weird and coordinated intervention by a bunch of central banks to address a so-called “liquidity crisis”.

What is this all about? Is it actually a credit crisis disguised as a liquidity crisis? Is it just another stealth way to bail out huge banks?

I’m going to take a stab at answering these questions, at the risk of talking out of my ass (and when has that ever stopped me?).

Finance is a big messy system, and it’s hard to know where to begin on the merry-go-round of confusion, but let’s start with European banks since they are the ones in need of funding.

European banks have lots of euros on hand, just as American banks have lots of dollars, because of the actual deposits they hold. However, European banks invest in American things (like businesses) that need them to come up with short term funding denominated in dollars. Similarly American banks invest in Europe, but that’s not really relevant to the discussion yet.

How do European banks get these short term (3 month) loans? Historically they do a large majority of it through money-markets: much of the money people have in banks is funneled to huge vats called money markets, and the fund managers of those vats are very very conservatively trying to make a bit of interest on them. In fact they were burned in the credit crisis, when they famously “broke the buck” on Lehman short-term loans.

Well, guess what, those same American money managers are avoiding European short-term loans right now, because they are super afraid of losing money on them. So that source of funding has dried up. Note that this is a credit problem: the money market managers do not trust the banks to be around in 3 months.

Another source of funding for the European banks’ American investments has been just to use their euros, exchange them to dollars (the currency market is very very large and liquid, especially on this particular exchange), then wait until the term of the short-term financing is over, and then convert the dollars back to euros. What actually happens, in fact, is that they borrow euros (at the going rate of 1%), do the exchange, then financing, and then get their money back in the future.

The guys who work at the European banks and who do this short-term financing aren’t allowed to take on the risk that the exchange rate is going to violently change between now and when the short-term term is over. Therefore they need to hedge the risk, which means they have to have a guarantee that the dollars they get out at the end of the term will be turned into a reasonable number of euros.

This kind of guarantee is called a currency swap, and the market for those is also very large and liquid, but has been less liquid recently because of the one-sidedness of this problem: European banks need short-term dollars but American banks don’t need euros at the same rate at the same maturity. So the end result is that the swaps are very very expensive for European banks.

Let’s put this another way, the way that seems strangest and most confusing: right now the European banks can borrow at 1% in euros but at 4% in dollars (for three month maturity), and more generally the demand for USD seems to be skyrocketing recently from all over the place. Does this mean there’s an arbitrage opportunity somewhere? The swaps market is at 3% so no obvious arbitrage. More likely it means that the markets are expecting the exchange rate to drastically change, or at least they are pricing in the risk of it changing violently in the very near future. (The strangest thing to me is why it hasn’t just changed the spot exchange rate as well.)

By the way, a pet peeve or two I have with people talking about arbitrage: firstly, many people use the term so loosely it means nothing at all, as when they take risk over time (exposing themselves to the possibility of an exchange rate change for example). But even here, I’m misusing the term, since in an arbitrage it’s literally supposed to be a way to make money risk-free, but the whole point of my post is that this is really all about counter-party risk! In other words, there’s no arbitrage opportunity to get into contracts with people where you’d make money except if they go bankrupt tomorrow, when there’s a good chance that will happen.

The bottomline is that although the ECB and the Fed and the other central banks have spun this as a coordinated effort to help out a liquidity squeezed but functional market, it doesn’t pass the smell test. What’s actually happening is that the shoddy accounting and investments of French banks and others is not being trusted by American money market managers who are wise to them.

One more thing: the collateral being asked of the European banks is purportedly of low standard, which is to say the ECB is allowing thing like Greek debt as collateral, which wouldn’t past muster with other institutions (or with U.S. money markets!). In that sense this can be seen as a stealth bailout, although I think not the first one in Europe under that definition. This isn’t going away until they figure out how to deal with the Greek debt problem.

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I think the central banks may be trying to drop a hint to the politicians ‘This is what cooperation looks like, now stop mucking around and cooperate’. However since the central bankers don’t have to get re-elected, they can co-operate more easily.

You can exchange currencies right now or agree to do so in 3 months at a rate fixed today (the horizontal arrows). You can also borrow in both currencies, ie, receive x USD today for the promise to repay x(1+r/4) USD in 3 months (the vertical lines; the 4 is so that r is comparable to an annual rate).

If you assume there is only one true 3m interest rate for each currency and perfect arbitrage, then this diagram shows how the forward FX rate is determined by the interest rates in the two currencies, something like FX_{3m} = FX_0 (1+r_{USD}/4) / (1+r_{EUR}/4).

In reality there is not a single true rate. And there is also no perfect arbitrage, ie, the diagram may not commute. The cross currency basis measures how much it fails to commute; you need to replace r_{USD} with r_{USD}+b, for some b < 0 now.

Starting with USD now (upper left), there are two paths in the diagram the leave you with USD in 3 months.

Two ways to understand why the arbitrage is not perfect: (1) your deposit is more at risk in a European bank than a US one, or in a European government bond than US bills, or (2) systemic flows are swamping the capability of market participants to take the other side and they demand a premium. Maybe (1) is more the "solvency" view and (2) is more the "liquidity" view, but they are mixed together. These days leg (2) where you hold EUR for 3 months results in more USD than leg (1) where you simply deposit your USD (assuming no defaults).

So that's my take on why the cross currency basis is a useful view of funding stress/credit differential between markets. Hopefully I didn't botch anything too bad — very interested to hear from anyone who knows more. Would also be cool to get the Snake Lemma in there.